Wednesday, February 18, 2015

The fear factor meets the Year Five Phenomenon

Despite
continued front-page fears over Greece’s threatened exit from the euro and the
military encroachments of the terrorist group known as ISIS, investors
apparently aren’t sufficiently worried enough to sell equities. If anything, adage about the “wall of worry”
has been the driving force behind recent equity market gains as the front-page
fears have been largely ignored.

Investors
were skittish entering 2015, so much so that billions were poured into safe
haven assets including U.S. Treasuries and precious metals. The soaring U.S. dollar (below) was as much a
sign of the flight to safety as it was a symptom of U.S. economic strength.

Since
the start of February, however, there has been a conspicuous change in
investors’ perceptions of the foreseeable future.To begin with, the sudden reversal of
investor fear can be seen in the chart of the iShares 20+ Year Treasury Bond
ETF (TLT), a proxy for the U.S. bond market.Treasury prices haven’t fallen this sharply since the May-September 2013
period, which also marked a period of increasing confidence in the future
outlook for U.S. consumers and investors.During that period, Treasuries and other safety assets underperformed
vis-à-vis risk assets such as stocks.

Another
indication that investors have cast off their worries (at least for now) is the
dramatic plunge in the Dow Jones Utility Average (DJUA). The utilities have given back all their gains
from the last two months and are experiencing their worst performance since
2013. Utility stocks normally follow the
direction of bond prices, so it’s not surprising to see the DJUA’s recent
weakness given the recent sell-off in Treasuries. The relatively higher yields that utility
stocks typically command along with their safety-oriented reputation make them
attractive to investors seeking safety.
The utilities benefited from the increased investor pessimism of the
late 2014/early 2015 period. Now the
safe haven utility stocks are suffering along with gold from the unwinding of
the “fear trade.”

Concomitant
with the subsiding of investor fear is the breakout to a record high in the New
Economy Index (NEI). NEI is comprised by
averaging the stock prices of the most economically sensitive companies within
the consumer retail and business sectors, including Amazon (AMZN), Fed-Ex
(FDX), and Wal-Mart (WMT). After
spending most of 2014 in a lateral trading range, NEI broke out above the
1-year trading range ceiling earlier this month and followed it up with another
high last week. The implication behind
the breakout in the NEI is that consumers and business owners are increasing
their spending levels as we head further into 2015, a sign of increasing
consumer confidence.

The
true state of the U.S. economy has been the subject of heated debate
lately. Going strictly by the accounts
offered by many respected economists, including Ed Yardeni and Scott Grannis,
spending levels on both the consumer and business levels are quite
healthy. Government statistics bear this
out, as do various consumer confidence polls.
Yet some analysts insist that the government’s numbers are “cooked” and
do not accurately reflect the underlying state of the economy.

According
to an Associated Press article, while the official unemployment rate has fallen
to 5.6 percent, average hourly wages have declined. It was also reported last month that a record
92,898,000 Americans are not currently in the workforce. One news service even reported that there are
still over 46 million Americans who are food stamp recipients. As one analyst concluded, “It is quite
obvious that the official numbers by the government are often very deceptive.”

So
who is right – the mainstream analysts who contend that the U.S. economy is on
the mend or the naysayers who claim the economy remains stuck in neutral (or
worse)? The source of the confusion can
be traced to misguided attempts at generalizing the enormous and multifaceted
U.S. economy. The economy is much like
the weather in that any attempt at creating a compressed generalization is
bound to cover a multitude of important details. The economy, much like the weather, covers a
broad geographic area can only produce a very sloppy “average” picture while
ignoring the scores of micro-climates within that picture. What is commonly called the “economy” is
simply a snapshot of the United States based on averaging the data within
various sectors.

Conventional
economic analysis also tends to lump the various socio-economic strata – namely
lower, lower-middle, middle, upper-middle and upper classes – into a single
broad category. Presently the U.S.
upper-middle and upper classes are in a much more prosperous condition than are
the lower-to-middle classes. Because the
higher income groups account for so much of the big ticket purchases it tends
to gloss over the fact that the middle and lower income strata have
lagged. This is one reason for the
differing accounts behind the U.S. recovery.

It’s
often overlooked that at its core the U.S. economy is essentially a financial
economy. The financial sector accounts,
directly or indirectly, for a huge percentage of total economic activity. This is why central bank policy is paramount
to the overall state of economic activity in America. Quantitative easing (QE) directly benefits
the financial market by inflating stock prices, which in turn benefits the
financial sector (the economy’s major component). As long as the financial sector is growing,
it’s only a matter of time before the rest of the economy follows suit.

There’s
no denying the strength in the New Economy Index (NEI) previously
discussed. An expanding NEI is tangible
proof that consumers are spending at increasing levels while businesses which
cater directly to consumers are also seeing increased sales. This will eventually filter into the broader
economic statistics used by economists.
NEI is essentially a real-time reflection of consumer spending levels.

In
the wake of the 1930s Great Depression, Freeman Tilden made this timely observation:

“In
a great state in prosperity, things are never as good as they seem; on the
other hand, in adversity they are never as bad as they seem. This is why contemporary prediction is nearly
always wrong. Long after a tottering state
should have fallen it is propped by the patient, law-abiding, submerged,
industrious and thrifty middle class, and by the mere habit of existing. The heart continues resolutely to beat.”

Sometimes
the lag between a financial market turnaround and a general recovery in
consumer finances can be quite long, as was the case in the 1930s and
1970s. Given that the U.S. suffered its
worst financial catastrophe since the Great Depression in 2008, it’s to be
expected that a broad-based economic recovery has been very slow in
arriving. As long as the financial
sector remains healthy and monetary liquidity remains loose, the beleaguered
middle class will eventually see improvement in its economic prospects. Despite proclamations to the contrary from
pundits, the U.S. middle class will emerge from the Great Recession in a
stronger state.